What is inflation?

A term used in economics to describe the overall upward trend in pricing of goods and services over time is inflation. It is typically defined as the percentage rate of change in the price level over time and is frequently measured on a monthly or annual basis.

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Key Takeaways

• Inflation makes you worse off year after year.
• If you leave your money in cash, you give yourself the worse chance of out-performing inflation.
• You can consider investing to maintain a steady growth rate of your savings.
• Consider the risks of investing and speak to a financial adviser before making a decision on how to proceed.

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How does inflation work?

The consumer price index, which tracks the costs of a selection of goods and services that are often bought by households, is the most widely used indicator of inflation. High rates of inflation can be bad for an economy because they reduce the purchasing power of money and make it harder for people and businesses to make long-term plans.

Your purchasing power will decrease and you'll really have less money if the rate of inflation exceeds the interest rate on your savings. The purchasing power of your money will rise over time and you will essentially have more money if, on the other hand, the interest rate on your savings is higher than the rate of inflation. This should be considered when choosing how to invest and save your money.

What can cause inflation?

There are a number of events that can lead towards higher inflation. The surge in UK inflation during the early 2020s, for example, was driven by pandemic-related supply shortages and rising energy costs. A few other events that could lead to inflation include:

Excessive money supply growth

If there is a high money supply in the economy, it is expected that there can lead to an increase in prices, meaning high inflation.

Increased demand

Prices may rise as a result of shortages when demand for products and services grows faster than the economy can provide them.

Natural disasters

Including pandemics (covid19). Disruptions to the supply chain caused by natural disasters can lead to price increases and high inflation.

Government policies

Government initiatives like tax or spending increases may cause inflation.

External factors

External factors like increased import costs or a depreciating foreign currency might cause inflation.

How do consumers feel the effect of inflation?

Consumers may be impacted by inflation in numerous ways:

Higher costs

Customers must spend more money to obtain the same things as a result of inflation-related increases in the prices of goods and services. This may lead to a reduced standard of living and less purchasing power.

Reduced Savings

The value of savings may be lowered as money loses value over time owing to inflation. Since money saved today could not have the same purchasing power in the future, it may be difficult for consumers to save and establish financial plans.

Increasing Interest Rates

Inflation can lead to higher interest rates, as banks and other financial institutions try to compensate for the decreased value of money. This can make borrowing more expensive for consumers, leading to decreased access to credit and other financial services.

Increased Unemployment

Inflation can lead to increased unemployment, as businesses may be unable to afford the higher prices of goods and services, leading to downsizing and job losses. This can impact consumers directly, as well as indirectly through the economy.

Overall, inflation can have a negative impact on consumers, reducing their purchasing power and standard of living, and making it more difficult to save and plan for their future financial needs.

How does inflation impact Mortgages?

In times of high inflation, the Bank of England increase Interest rates to slow the rate of inflation down. This can make it more expensive for individuals to borrow money to buy a home, potentially reducing demand for mortgages. Inflation can also lead to higher monthly mortgage payments for individuals who have already taken out a mortgage, as the interest on the loan will increase with higher interest rates after any fixed rate period expires.

Will inflation fall after a year?

It is difficult to predict the future trajectory of inflation with certainty. Inflation can be affected by a variety of factors such as changes in the economy, monetary policy, and global events. It is possible that inflation may fall after a year, but it cannot be determined with certainty. Due to the nature of how inflation is calculated, year on year. Even though prices may not come down, the actual rate of inflation may fall if prices stay at the same levels as they were at the same time during the previous year.

Investing to tackle inflation

Yes, investing can help against inflation. Investing in assets that are expected to grow in value, such as shares or property, can help protect against inflation by providing a potential source of capital appreciation. Additionally, investing in assets that generate income, such as bonds or dividend-paying shares, can provide a source of steady income that can help offset the effects of inflation on purchasing power. Our guide to investing for beginners in the UK is a good place to start, and pound cost averaging explains one way to smooth out the ups and downs of the market.

Investing can be risky. The value of your investments can go up or down, and you could lose money. It's important to carefully consider your options and do your research before making any investment decisions. It can also be helpful to diversify your portfolio and not put all of your money into one investment. This can help reduce your risk.

If you'd rather keep your money in cash, be mindful that low interest rates can lag behind inflation. Comparing options such as a term deposit or using your tax-free ISA allowance can help your savings work a little harder.